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Pension Fund Speculation Drives Long Bond
Investors Run Out Front of Potential Regulatory Change
By Noel Lamb, Chief Investment Officer — North America
Russell Investment Group
Global Leaders in Multi-Manager Investing
March 2, 2005
The following article has been issued by our parent Frank Russell Company in Tacoma, Washington and is referring specifically to the US market unless otherwise stated.
Among the best market performers during the first seven weeks of the year was an unlikely contender: A financial instrument that the government no longer issues and that had been all but written off as a revenue producer for 2005.
Yet the 30-year Treasury, or long bond, returned a whopping 3.2% year-to-date through February 18. Were such a performance extended over a year it would amount to more than 20%.
Meanwhile large-cap growth stocks, which were predicted to be the stars of 2005, were down 2.57%, as measured by the Russell Top 200® Growth Index, over the same time. That's a 5.7% difference in just seven weeks.
The trend is the opposite of that predicted for 2005 by money managers surveyed by Russell in December. They were most bullish on growth stocks; least on bonds.
In addition, the US Federal Reserve Board has raised the short-term Federal Funds to 2.5%. Yet the long bond has been moving in the opposite direction of expectations. The 20-year Treasury bond also has been gaining, having returned 2.9% for the year to February 18.
Greenspan's "Conundrum"
The phenomenon even has US Federal Reserve Chairman Alan Greenspan perplexed. He recently called it a "conundrum" in testimony before the US Congress.
True, the year is yet young and much could happen before it ends. Also, the star performers of the first few weeks of 2005 are only those at the long end of the Treasury bond scale. The shorter-term 2-year Treasury bond, for example, fell 0.23% over the same time.
But it remains surprising that the long bond — which was discontinued in late 2001 and is now a 27-year bond — is the strong performer as 2005 gets under way. After all, the economy appears to be on a growth pattern, terrorism fears have receded, interest rates remain at historical lows and inflation seems to pose little threat.
Pension Liabilities
The main reason for the bond's strong performance appears to be pressure from potential new legislation in the US on pension plans to match their liabilities more closely with specific assets. Their liabilities lie 20-30 years out when many of today's contributors retire and new legislation requires them to better cover their liabilities. Hence, they will be using long bonds as their assets to match those liabilities.
Their action may increase demand for the long bond and so drive up prices.
Speculators, aware of the potential pressure on the pension funds, are jumping in to take advantage of that move, hoping to be the holders of scarce assets that pension funds may be forced to buy.
A second reason that might be prompting investors to buy long bonds is one that is driving investors into bonds generally. Following sharp falls in the equity markets from 2000 to 2002, many investors became risk averse. They saw bonds as a safe haven.
Even though the broad-market Russell 3000® Index rose some 30% in the second half of 2003, the collective memory of investors may still recall the bear market that preceded it. This, in part, explains the strong performance of the bond market and the rally that continued throughout 2004 into 2005.
Uncertain Economic Growth
In addition, fear is growing among some analysts that economic growth might not be as certain as some had expected. Many companies might find the cost of doing business growing, but they are unable to increase prices because they fear demand might dry up if they do. The result then would be eroding profits.
Some fear the US Federal Reserve will continue to raise rates and will do so too rapidly. Too many quick rate hikes could put the brakes on consumer spending and smother the incipient economic recovery. These analysts point to the large amount of debt accumulated by homeowners that is sensitive to moves in short rates, typically adjustable rate mortgages, and, to a lesser extent, credit card debt tied to the prime rate
Corporate spending, too, might be crimped by the Fed continuing to move rates higher as many corporations have financed business through short-term borrowing, which will have a higher cost as the Fed raises rates.
Investors therefore may be moving out of stocks into long bonds to protect their capital should stocks slump.
Once again, the market's surprise confirms the validity of the principle of diversified asset allocation. That way, whichever sector is the best performing, it is likely to form a part of an investors' portfolio.
This is a publication of Russell Investments Canada Limited. Nothing in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The contents in this publication are intended for general information purposes only and should not be acted upon without obtaining specific legal, tax, and investment advice from an investment professional concerning your own situation and any specific investment questions you may have.
The information, including any opinion, is based upon various sources we believe to be reliable but its accuracy cannot be guaranteed. It is for information only, is subject to change at any time, and does not constitute an offer or solicitation to buy or sell securities referred to.
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